Can ecological models explain global financial markets--and make them more stable?

Bananas, cacao and bee-pollinated crops are all threatened with collapse in part because of their monoculture management. When a biological or social system is full of uniform individuals—be they bean plants or banks—one shared weakness can spell disaster for the whole lot. Even when a new beneficial trait or tool enters the picture, if all organisms adopt it, as many financial institutions did with credit default swaps and other risky trades that led to the financial meltdown of 2007-08, a tenuous balance can be quickly upset, argued an economist and an ecologist in a new essay.

"Excessive homogeneity within a financial system—all the banks doing the same thing—can minimize risk for each individual bank, but maximize the probability of the entire system collapsing," Bank of England's Andrew Haldane and Oxford University's Zoology Department's Robert May wrote in their new paper, which will be published in the January 20 issue of Nature (Scientific American is part of Nature Publishing Group). Thus even as banks themselves were pursuing internal diversity by adopting new financial tools, across the board "banks' balance sheets and risk management systems became increasingly homogenous," they wrote. And that similarity led to a vulnerable system.

A thoroughly interconnected food—or financial—web might provide the illusion of security, as "high connectivity distributes, and thereby attenuates risk." But as the authors pointed out, when a shock does hit the system, it will affect more institutions.

One way to combat this issue is to establish more self-contained "nodes" as has been employed in forest management and even computer networks, so that if one element takes a hit, it doesn't take down the entire system.

And rather than regulating with the aim of individual institution stability, Haldane and May noted, attention should be tuned to the overall system's risk. Like the spread of an infectious disease, financial troubles can be launched by so-called "super-spreaders," such as Lehman Brothers. By "focusing preventive action on 'super-spreaders' within the network to limit the potential for system-wide spread," regulators might be able to avoid the contagious hemorrhaging that occurred with the 2008 Lehman Brothers collapse.

Not everyone is convinced the ecological model is ready to be incorporated into policy-making decisions. Haldane and May asserted—and reasserted—that the dynamics they present are "deliberately oversimplified" and that "there are, of course, major differences between ecosystems and financial systems" (including preference of speed over long-term fitness and the interference of governments). Nevertheless, "rigorous statistical validation of any toy model or analogy is essential before policies are suggested," asserted University of Miami physicist Neil Johnson in an essay published in the same issue of Nature. By way of comparison, he asked: "Would you fly in a paper plane that had been scaled up to the size of a 747?"

But other non-biologists are ready to entertain the ecological model. University of Kiel economics professor Thomas Lux noted in another essay in the same issue of Nature that it is "essential" to "take stock of the accumulated knowledge on network structures when studying systemic risk in the banking sector."

Whether or not experts agree that biology is a useful lens through which to study financial markets, Haldane and May suggested that financial regulation is already "following in the footsteps of ecology, which has increasingly drawn on a system-wide perspective when promoting and managing ecosystem resilience."

Image courtesy of iStockphoto/ene

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